1. Why is the "Cost of Debt" generally lower than the "Cost of Equity"?
Interest paid on debt is tax-deductible, creating a tax shield.
Equity holders have a fixed claim on assets.
Lenders take higher risk than shareholders.
Debt does not require repayment.
Explanation:
Interest payments reduce the taxable income of the company, effectively lowering the cost of debt by the tax rate [Kd = I(1-t)]. Equity dividends are paid out of post-tax profits and offer no tax shield.
2. In the CAPM (Capital Asset Pricing Model), "Beta" measures:
Risk-free rate.
Unsystematic Risk (Company specific).
Systematic Risk (Market risk) relative to the market.
Total Risk.
Explanation:
Beta indicates how volatile a stock is compared to the overall market. Beta > 1 means higher volatility than the market; Beta < 1 means lower volatility.
3. The "Cost of Retained Earnings" is usually estimated to be:
Equal to the Cost of Equity (Ke).
Higher than Cost of New Equity.
Zero.
Equal to the Cost of Debt.
Explanation:
Retained earnings involve an opportunity cost. Shareholders forgo dividends to let the firm reinvest. They expect a return equal to what they would demand on equity shares (Ke).
4. The cost of raising an *additional* rupee of capital is called:
Marginal Cost of Capital.
Fixed Cost.
Sunk Cost.
Average Cost of Capital.
Explanation:
Marginal cost is the incremental cost of new capital. It is the relevant rate for evaluating new investment proposals.
5. Which weights are theoretically superior for calculating WACC (Weighted Average Cost of Capital)?
Marginal Weights.
Book Value Weights.
Historical Weights.
Market Value Weights.
Explanation:
Market values reflect the current economic value of the capital employed. Using market value weights aligns the WACC with the actual cost of raising new capital in the market today.
6. Formula for Cost of Equity (Ke) under CAPM is:
Rf - Beta(Rm - Rf)
Rf + Beta(Rm - Rf)
(D1 / P0) + g
Rm + Beta(Rf)
Explanation:
Ke = Risk Free Rate + [Beta * (Market Return - Risk Free Rate)]. This adds a risk premium to the safe rate based on the stock's volatility.
7. The "Cost of Preference Share Capital" is calculated as:
Preference Dividend * (1 - Tax Rate) / Net Proceeds
Preference Dividend / Net Proceeds
Interest / Net Proceeds
Preference Dividend / Market Price
Explanation:
Preference dividends are not tax-deductible, so no tax adjustment is made. Cost = Dp / NP.
8. How do "Floatation Costs" affect the Cost of New Equity?
They reduce the dividend payout.
They increase the Cost of Equity.
They have no impact.
They reduce the Cost of Equity.
Explanation:
Floatation costs (issue expenses) reduce the "Net Proceeds" the company receives from the issue. Since the denominator (Net Proceeds) decreases, the calculated Cost of Capital increases.
9. Which of the following is NOT an assumption of the Capital Asset Pricing Model (CAPM)?
All investors have different expectations about future returns.
Investors are rational and risk-averse.
Markets are perfect (no taxes, no transaction costs).
Investors hold diversified portfolios.
Explanation:
CAPM assumes "Homogeneous Expectations" - that all investors have the same expectations regarding expected returns, variances, and correlations.
10. Retained Earnings have an "Implicit Cost" because:
It is free money.
It is recorded in books.
The shareholders forego the opportunity to invest dividends elsewhere.
The company pays interest on it.
Explanation:
Explicit costs involve cash outflow (interest). Implicit costs are Opportunity Costs. The cost of retained earnings is the return shareholders could have earned if the money was distributed.
11. When calculating the "Cost of Redeemable Debt", which factor is NOT considered?
Dividend Payout Ratio.
Tax Rate.
Redemption Value and Maturity Period.
Interest Rate.
Explanation:
Cost of Debt depends on interest, tax shield, and redemption terms (discount/premium). Dividend Payout Ratio is relevant for Cost of Equity, not Debt.
12. The "Marginal Cost of Capital" (MCC) schedule jumps (breaks) upwards when:
Interest rates fall.
Tax rates fall.
The firm has excess cash.
The amount of new capital raised exhausts a cheaper source (like Retained Earnings) and requires a more expensive source (like New Equity).
Explanation:
This point is called the "Break Point". Once retained earnings are used up, the firm must issue new shares (incurring floatation costs), which raises the WACC.
13. In the Security Market Line (SML) graph, if a stock lies ABOVE the SML line, it is considered:
Correctly Valued.
High Risk.
Undervalued.
Overvalued.
Explanation:
If a stock is above the SML, it is offering a higher expected return than what CAPM predicts for its level of risk. Hence, it is attractive/undervalued and should be bought.